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**Free Cash Flow Valuation**

Presenter Venue Date In Chapter 3, we used dividends as the measure of shareholder cash flow in stock valuation. In Chapter 4, we will utilize free cash flow. Whereas dividends are the cash flow actually paid to shareholders, free cash flow (FCF) is the cash flow available to shareholders. Unlike dividends, data on free cash flows are not readily available. Stock analysts must interpret financial statements to determine free cash flows. Although free cash flow analysis can prove quite challenging, many analysts consider free cash flow models more relevant than dividend discount models. In this chapter, we begin by examining two definitions of free cash flow. We then discuss the determination of free cash flows so that they can be used in valuation models. We will use models similar to dividend discount models (DDMs) such as the stable-growth model, two-stage model, and three-stage model. DISCLAIMER: This presentation is NOT a substitute for the CFA Program curriculum. Candidates should not view this material as reflecting what will be required of them on the CFA exam.

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**Free Cash Flow Free Cash Flow to the Firm = Cash flow available to**

Common stockholders Debtholders Preferred stockholders Free Cash Flow to Equity LOS: Define and interpret free cash flow to the firm (FCFF) and free cash flow to equity (FCFE). Page 147 Free cash flow to the firm (FCFF) is the cash flow available to all the firm’s suppliers of capital once the firm pays all operating expenses (including taxes) and expenditures needed to sustain the firm’s productive capacity. The expenditures include what is needed to purchase fixed assets and working capital, such as inventory. The firm’s suppliers of capital include common stockholders, bondholders, and preferred stockholders (if the firm has preferred stock outstanding). Free cash flow to equity (FCFE) is the cash flow available to the firm’s common stockholders once operating expenses (including taxes), expenditures needed to sustain the firm’s productive capacity, and payments to (and receipts from) debtholders are accounted for. Note that the cash flow from operations as reported in the firm’s financial statements is not the same as free cash flow. Later, however, we will adjust the firm’s financial statement figures to derive free cash flow. Unadjusted financial income measures—such as earnings before interest, taxes, depreciation, and amortization (EBITDA)—do not provide an accurate description of the free cash flow available to the firm’s capital providers. For example, EBITDA and net income do not account for the investment in assets needed to sustain the firm’s productive capacity.

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**FCFF vs. FCFE Approaches to Equity Valuation**

Equity Value FCFF Discounted at WACC – Debt Value FCFE Discounted at Required Equity Return LOS: Describe, compare, and contrast the FCFF and FCFE approaches to valuation. LOS: Describe the characteristics of companies for which the FCFF model is preferred to the FCFE model. Pages 147 – 148 There are two ways to estimate the equity value using free cash flows. An entire firm and all its cash flows (FCFF) are discounted, with the relevant discount rate being the weighted average cost of capital (WACC) because it reflects all the firm’s sources of capital. The value of the firm’s debt is then subtracted to calculate the equity value. Only the free cash flows to equity (FCFE) are discounted, with the relevant discount rate being the required return on equity. This provides a more direct way of estimating equity value. In theory, both approaches should yield the same equity value if the inputs are consistent. However, the FCFF approach would be favored in two cases. The firm’s FCFE is negative. The firm’s capital structure (mix of debt and equity financing) is unstable. The FCFF approach is favored here because a) the required return on equity used in the FCFE approach will be more volatile when the firm’s financial leverage (use of debt) is unstable and b) when using historical data to estimate free cash flow growth, FCFF growth might reflect the firm’s fundamentals better than FCFE growth, which would fluctuate as debt fluctuates. Text Integration Note: The estimation of the WACC (weighted average cost of capital) was covered in Chapter 2 of the Equity Asset Valuation text.

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**FCFF vs. FCFE Approaches to Equity Valuation**

LOS: Describe, compare, and contrast the FCFF and FCFE approaches to valuation. Pages 148 – 149 Another way of differentiating the FCFF and FCFE approaches to valuation is to examine the respective valuation formulas. On this slide, we show the valuation formulas using the FCFF approach on the top two lines and the FCFE approach on the third line. The FCFF approach says that the value of the firm is equal to the infinite stream of FCFF discounted by the WACC. The market value of debt is then subtracted to arrive at the equity value. The FCFE approach says that the value of equity is equal to the infinite stream of FCFE discounted by the required return on equity (r).

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**Single-Stage Free Cash Flow Models**

LOS: Calculate the value of a company by using the stable-growth, two-stage, and three-stage FCFF and FCFE models. Pages 149 – 150 If we assume that free cash flows grow at a constant rate forever, the FCFF and FCFE valuation models can be rewritten in a form that is very similar to the Gordon growth model in Chapter 3. On this slide, we show the single-stage (stable-growth) valuation formulas using the FCFF approach on the top two lines and the FCFE approach on the third line. The FCFF approach says that the value of the firm is equal to next period’s FCFF divided by the WACC minus the growth in FCFF (g). The market value of debt is then subtracted to arrive at the equity value. The FCFE approach says that the value of equity is equal to next period’s FCFE divided by the required return on equity (r) minus the growth in FCFE (g). Note that the growth rate for FCFF and FCFE need not be and frequently are not the same. On the next slide, we’ll do an example using the FCFF approach.

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**Example: Single-Stage FCFF Model**

Current FCFF $6,000,000 Target debt to capital .25 Market value of debt $30,000,000 Shares outstanding 2,900,000 Required return on equity 12 .0% Cost of debt 7 Long-term growth in FCFF 5 Tax rate 30 % LOS: Calculate the value of a company by using the stable-growth, two-stage, and three-stage FCFF and FCFE models. Pages 149 – 150, Spreadsheet Example The solution is on the slides to follow.

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**Example: Single-Stage FCFF Model**

LOS: Calculate the value of a company by using the stable-growth, two-stage, and three-stage FCFF and FCFE models. Pages 149 – 150, Spreadsheet Example We first must calculate the WACC for the firm. The formula says the weighted average cost of capital (WACC) is equal to debt and equity component costs. MV(Debt) = current market value of debt MV(Equity) = current market value of common equity rd = before-tax cost of debt (which is transformed into the after-tax cost by multiplying by 1 – Tax Rate) r = cost of equity To calculate the debt component, the tax rate is used because in most jurisdictions, the interest payments on debt are tax deductible, which reduces the effective cost of debt financing. Equity however is not tax advantaged because the payment of dividends does not reduce the firm’s taxable income. Plugging in the numbers from our example, we arrive at a WACC = percent. Note that the debt to capital ratio of 0.25 means that 25 percent of firm assets are financed with debt and the other 75 percent are financed with equity. In some cases (as in this example), analysts use the ratio of target debt to capital ratio instead of using current market value weights because analysts frequently assume that the targeted debt ratio is that which the firm will utilize over the long term.

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**Example: Single-Stage FCFF Model**

LOS: Calculate the value of a company by using the stable-growth, two-stage, and three-stage FCFF and FCFE models. Pages 149 – 150, Spreadsheet Example Next, we use our estimate of the WACC and plug it into the stable-growth FCFF models. We grow the current $6 million in FCFF out one period at 5 percent to arrive at next period’s FCFF. The debt value of $30 million is subtracted from the firm value to arrive at an equity value of $90.5 million. On a per share basis, the equity value is $ Note that your final answer may differ by a few cents from the above due to rounding. Note also that here the FCFF is discounted by the firm’s WACC. If the FCFE were provided, it would be discounted by the shareholder’s required return to obtain the equity value. On the next slide, we’ll look at how FCFF would be calculated using the firm’s financial statements.

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**Using Net Income to Determine FCFF**

LOS: Discuss the appropriate adjustments to net income, earnings before interest and taxes (EBIT), earnings before interest, taxes, depreciation, and amortization (EBITDA), and cash flow from operations (CFO) to calculate FCFF and FCFE. Pages 151 – 154 In the formula above: NI = net income NCC = net noncash charges Int = interest expense FCInv = investment in fixed capital (commonly known as capital expenditures) WCInv = investment in working capital The basic approach is to adjust financial statement flows so that they better reflect the cash flow available to all investors in the firm. Net income is the bottom line on the income statement and is after all charges except for common dividends. We will adjust net income to arrive at FCFF, which is the cash flow available to all the firm’s capital providers. Depreciation expense is typically the largest NCC and is added back to net income. Depreciation expense is a method of recognizing the cost of a piece of equipment over its life. In the year depreciation expense is reported, it is not actually incurred, so it is added back to obtain FCFF. Interest expense was subtracted out to obtain net income and is available to one of the firm capital providers (the debtholders), so it is added back. We use after-tax interest expense because the WACC we use to discount FCFF is after tax. Investment in fixed capital is a cash outflow used to support the firm’s current and future operations and is subtracted out. Any cash the firm receives from selling assets would be netted from capital expenditures. Lastly, we subtract out investments in working capital, where working capital is current assets/current liabilities, excluding cash and notes payable and current portion of long-term debt. We exclude cash because it is the amount we are trying to explain. We exclude notes payable and current portion of long-term debt because they are financing amounts, not operating amounts (i.e., they were not used to calculate net income, so we don’t have to use them to adjust net income to FCFF). In the formula, we assumed the firm did not have preferred shareholders. If it did, we would add preferred dividends to obtain the FCFF because net income is net of preferred dividends.

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**Other Noncash Adjustments**

Added back Amortization Restructuring Expense Subtracted out Restructuring Income Capital Gains Capital Losses Employee Option Exercise Added back? Deferred Taxes Subtracted out? Tax Asset LOS: Discuss the appropriate adjustments to net income, earnings before interest and taxes (EBIT), earnings before interest, taxes, depreciation, and amortization (EBITDA), and cash flow from operations (CFO) to calculate FCFF and FCFE. LOS: Discuss approaches for forecasting FCFF and FCFE. Pages 157 – 163 As mentioned previously, depreciation expense is typically the largest noncash adjustment and is added back to net income to determine FCFF. The working capital accounts as recorded in the WCInv were also adjusted for noncash events. Other adjustments for noncash events to net income are as follows: If the firm amortizes intangibles, that expense should be added back to net income to determine FCFF. When the firm amortizes a bond discount, that would also be added back. Note, however, that the amortization of a bond premium would be subtracted out. If the firm records a restructuring expense that is a noncash event, then that amount should be added to net income to determine FCFF. However, if the restructuring expense is meant to cover future firm expenses, then forecasts of future FCFF should be reduced by those amounts. If the firm records restructuring income that is a noncash event (e.g., the firm reverses an earlier accrual), then that amount should be subtracted from net income to determine FCFF. If the firm sells an asset that has a book value of $60,000 for $100,000, $40,000 will be recorded as a capital gain in the net income. This $40,000 amount is noncash and should be subtracted out. Note, however, that the $100,000 is classified under FCInv and is thus a cash inflow. A capital loss would be added back, with the cash sale proceeds as an inflow to FCInv. The exercise of employee stock options results in cash for the firm. However, the analyst should forecast FCFF per share on a basis that reflects the additional shares that will result from option exercise. Changes in deferred tax liabilities would be added back to net income if the firm will be able to consistently defer taxes in the future. If, however, the deferred tax charge will reverse in the future, then this amount would not be added back. Likewise, sometimes a firm has tax assets as a result of the firm recording charges that are not deductible for tax purposes. In this case, taxes on the financial statement are lower than taxes actually paid and the firm records a tax asset. If the firm expects this to be a persistent situation, then future net income should be adjusted downward. If it is expected to reverse, however, no adjustment needs to be made.

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**Using EBIT and EBITDA to Determine FCFF**

LOS: Discuss the appropriate adjustments to net income, earnings before interest and taxes (EBIT), earnings before interest, taxes, depreciation, and amortization (EBITDA), and cash flow from operations (CFO) to calculate FCFF and FCFE. Pages 169 – 170 In the formulas above: EBIT = earnings before interest and taxes Dep = depreciation EBITDA = earnings before interest, taxes, depreciation, and amortization FCInv = investment in fixed capital (commonly known as capital expenditures) WCInv = investment in working capital Now we work with a number higher on the income statement than net income to calculate FCFF. On the previous slide, we added back interest expense because interest is subtracted out to arrive at net income. Because EBIT and EBITDA are calculated before interest expense is subtracted out, we do not need to add it back here. In the formulas on this slide, we assume that the only net noncash charge is depreciation, so NCC = Dep. If starting with EBIT, we need to add back depreciation because it was subtracted to obtain EBIT. If starting with EBITDA, we add back only the depreciation tax shield (Dep × Tax Rate = Amount the firm saves on taxes by being able to claim the noncash depreciation expense). We add it back because although EBITDA is before depreciation, the depreciation tax shield saves the firm on taxes and adds to its cash flows. As on the previous slide, we subtract out investments in fixed assets (FCInv) and working capital (WCInv) to obtain FCFF.

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**Using Cash Flow from Operations to Determine FCFF**

LOS: Discuss the appropriate adjustments to net income, earnings before interest and taxes (EBIT), earnings before interest, taxes, depreciation, and amortization (EBITDA), and cash flow from operations (CFO) to calculate FCFF and FCFE. Pages 155 –156 In the formula above: CFO = cash flow from operations Int = interest expense FCInv = investment in fixed capital (commonly known as capital expenditures) Analysts often start with CFO to calculate FCFF because CFO already reflects depreciation expense, other noncash charges, and investments in working capital. We need to add back interest because it was subtracted out to obtain CFO and it is available to one of the firm’s capital providers (the debtholders). As on the previous slides, investment in fixed capital is a cash outflow used to support the firm’s current and future operations and is subtracted out. Any cash the firm receives from selling assets would be netted from capital expenditures.

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**Calculating FCFE from FCFF, Net Income, & CFO**

LOS: Discuss the appropriate adjustments to net income, earnings before interest and taxes (EBIT), earnings before interest, taxes, depreciation, and amortization (EBITDA), and cash flow from operations (CFO) to calculate FCFF and FCFE. Pages 163 – 170 Once we have the FCFF, we can easily calculate the FCFE. Recall that the FCFF is the cash flow available to all firm capital providers, whereas the FCFE is the cash flow available to only the common equityholders. Therefore, in the first formula, we subtract interest payments from FCFF because they are not available to common equityholders. We add net borrowing to FCFF because it is the cash flow available to common equityholders. (If the firm has preferred shareholders, then preferred issuance amounts would also be added to get FCFE.) Recognizing the relationship between FCFF and FCFE in the top formula, we can then calculate FCFE by using the formulas that calculated FCFF from net income and CFO. Substitution into the FCFF formulas results in formulas for the FCFE. We could also do this for the formulas for EBIT and EBITDA if we wished. Note that the FCFE will be different in magnitude from dividends because the FCFE is the amount available to be paid to common equityholders, whereas dividends are the amount actually paid out. Dividends are at the discretion of the board of directors, and firms prefer to gradually increase the dividend amount. So they will not usually pay out all their earnings because they do not want to have to cut the dividend later.

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**FCFE & FCFF on a Uses of FCF Basis**

LOS: Discuss the appropriate adjustments to net income, earnings before interest and taxes (EBIT), earnings before interest, taxes, depreciation, and amortization (EBITDA), and cash flow from operations (CFO) to calculate FCFF and FCFE. Pages 171 – 172 Previously, we calculated FCFF and FCFE by examining the sources of FCF (e.g., we adjusted net income, which was a source of FCF). We could also calculate FCFE and FCFE by examining the uses of FCF. Under this approach, we would start with the change in the firm’s cash balance and then adjust that for the use of cash flow. In general, a firm has three alternative uses of FCF: 1) Retain the cash; 2) pay it to debtholders; or 3) pay it to stockholders. The advantage of the uses approach is that we can examine how the firm’s capital structure changes. If the firm uses FCF from the issuance of equity to pay down debt, then the firm has decreased its leverage. If the firm uses FCF from the issuance of debt to pay dividends or repurchase stock, then the firm has increased its leverage. In the formulas on the slide, we start with change in cash balance and then add net payments to debtholders and stockholders to obtain FCFF. For FCFE, we follow the same process but just add net payments to stockholders. The values we obtain should be the same as the values when we calculate FCFF and FCFE using the sources of FCF. In the slides to follow, we will practice calculating FCFF and FCFE using the formulas we have covered. You will see that regardless of the formula used, we end up with the same numbers for FCFF and FCFE.

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**Example: Calculating FCFF**

EBITDA $1,000 Depreciation expense $400 Interest expense $150 Tax rate 30 % Purchases of fixed assets $500 Change in working capital $50 Net borrowing $80 Common dividends $200 LOS: Discuss the appropriate adjustments to net income, earnings before interest and taxes (EBIT), earnings before interest, taxes, depreciation, and amortization (EBITDA), and cash flow from operations (CFO) to calculate FCFF and FCFE. LOS: Calculate FCFF and FCFE when given a company’s financial statements prepared according to International Financial Reporting Standards (IFRS) or U.S. generally accepted accounting principles (GAAP). Pages 151 – 172, Spreadsheet Example The solution is on the next slide.

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**Example: Calculating FCFF from Net Income**

LOS: Discuss the appropriate adjustments to net income, earnings before interest and taxes (EBIT), earnings before interest, taxes, depreciation, and amortization (EBITDA), and cash flow from operations (CFO) to calculate FCFF and FCFE. LOS: Calculate FCFF and FCFE when given a company’s financial statements prepared according to International Financial Reporting Standards (IFRS) or U.S. generally accepted accounting principles (GAAP). Pages 151 – 172, Spreadsheet Example We start our examples of calculating FCFF and FCFE by using the formula for FCFF and net income. We first must obtain net income from the example provided, which is the EBITDA after depreciation, interest, and taxes: ($1000 – $400 – $150)(1 – 0.30) = $315. Assuming that depreciation expense is the only NCC, the resulting value for FCFF is $270. Notice that to get net income, we subtracted depreciation and interest from EBITDA. To get FCFF, we added them back. This suggests that we could have calculated FCFF more easily by working higher on the income statement at EBITDA. This is what we do on the next slide.

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**Example: Calculating FCFF from EBIT and EBITDA**

LOS: Discuss the appropriate adjustments to net income, earnings before interest and taxes (EBIT), earnings before interest, taxes, depreciation, and amortization (EBITDA), and cash flow from operations (CFO) to calculate FCFF and FCFE. LOS: Calculate FCFF and FCFE when given a company’s financial statements prepared according to International Financial Reporting Standards (IFRS) or U.S. generally accepted accounting principles (GAAP). Pages 151 – 172, Spreadsheet Example We first must obtain EBIT from the example provided, which is the EBITDA after depreciation: $1000 – $400 = $600. Calculating FCFF using EBIT, we again arrive at $270. Starting higher on the income statement at EBITDA, we again calculate $270. Recall our discussion from the previous slide where we first examined the EBIT and EBITDA formulas: If starting with EBIT, we add back depreciation because it was subtracted to obtain EBIT. If starting with EBITDA, we add back only the depreciation tax shield (Dep × Tax Rate = Amount the firm saves on taxes by being able to claim the noncash depreciation expense). We add it back because although EBITDA is before depreciation, the depreciation tax shield saves the firm on taxes and adds to its cash flows.

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**Example: Calculating FCFF from CFO**

LOS: Discuss the appropriate adjustments to net income, earnings before interest and taxes (EBIT), earnings before interest, taxes, depreciation, and amortization (EBITDA), and cash flow from operations (CFO) to calculate FCFF and FCFE. LOS: Calculate FCFF and FCFE when given a company’s financial statements prepared according to International Financial Reporting Standards (IFRS) or U.S. generally accepted accounting principles (GAAP). Pages 151 – 172, Spreadsheet Example Next we calculate FCFF from cash flow from operations. We first must obtain CFO from the example provided, which is the net income plus depreciation minus the change in working capital: $315 + $400 – $50 = $665. Using the formula for FCFF, we again obtain $270. We add back interest because it was subtracted out to obtain CFO and it is available to one of the firm’s capital providers (the debtholders). The investment in fixed capital is a cash outflow that was not included in the calculation of CFO, so it is subtracted out.

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**Example: Calculating FCFE from FCFF, Net Income, & CFO**

LOS: Discuss the appropriate adjustments to net income, earnings before interest and taxes (EBIT), earnings before interest, taxes, depreciation, and amortization (EBITDA), and cash flow from operations (CFO) to calculate FCFF and FCFE. Pages 163 – 170, Spreadsheet Example Turning our attention to FCFE, we see that it can be easily calculated from FCFF. We subtract interest payments from FCFF because they are not available to common equityholders. We add net borrowing to FCFF because these are cash flows available to common equityholders. This results in a FCFE of $270 – $150(0.70) + $80 = $245. We can also calculate the same FCFE amount using the formulas that start from net income and CFO. This again results in $245 in both cases.

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**Example: Calculating FCFE & FCFF on a Uses Basis**

LOS: Discuss the appropriate adjustments to net income, earnings before interest and taxes (EBIT), earnings before interest, taxes, depreciation, and amortization (EBITDA), and cash flow from operations (CFO) to calculate FCFF and FCFE. Pages 171 – 172, Spreadsheet Example Lastly, we calculate FCFF and FCFE from a uses basis. We start by calculating net payments to debtholders and stockholders. For the net payments to debtholders, the firm has no debt repayments, so the net payments to debtholders equals after-tax interest net of debt issuances: $150(0.70) – $80 = $25. For the net payments to stockholders, the firm has no stock repurchases or issuances, so the net payments to stockholders equals the dividends of $200. In this example, the change in cash balance is calculated from the statement of cash flows as the CFO minus investing activities (FCInv) minus financing activities (net borrowing minus the common dividends): $665 – $500 + $80 – $200 = $45. The FCFF is then calculated as the change in cash plus any cash flows to/from the firm’s capital providers: $45 + $25 + $200 = $270. The FCFE is calculated as the change in cash plus any cash flows to/from the firm’s stockholders: $45 + $200 = $245. Using the formulas for our example, we have seen that regardless of the formula used, we end up with $270 for FCFF and $245 for FCFE.

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**Forecasting FCFF & FCFE**

LOS: Discuss approaches for forecasting FCFF and FCFE. Pages 173 –177 Two approaches are commonly used to forecast FCFF and FCFE: 1) Use historical free cash flow, and apply a growth rate under the assumptions that growth will be constant and firm fundamentals are unchanged. 2) Forecast the underlying components of free cash flow. This relates sales growth to future capital expenditures, depreciation expenses, and changes in working capital. Capital expenditures are assumed to have two components: outlays needed to maintain existing capacity (fixed capital replacement) and outflows needed to support growth. The first outlay is related to the current level of sales, and the second depends on the predicted sales growth. We estimate incremental capital expenditures as FCInv – Depreciation (i.e., that in excess of depreciation). When forecasting FCFE, we assume that a firm maintains a constant target debt financing ratio (DR) for net new investment in fixed capital and working capital. This assumption allows forecasts of FCFE without having to specifically forecast debt issuance or repayment. In the formulas above: EBIT = earnings before interest and taxes FCInv = investment in fixed capital WCInv = investment in working capital DR = target debt ratio NI = net income Dep = depreciation We forecast FCFF as the after-tax EBIT minus the change in capital expenditures and WCInv that occurs with sales growth. This method will yield the same result as previous equations if depreciation is the only noncash expense. The formula for FCFE says that FCFE is equal to net income minus the incremental capital expenditures and WCInv financed by equity (1 – DR). The example on the next slide illustrates the calculations.

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**Example: Forecasting FCFF & FCFE**

Sales $4,000 Sales growth $200 EBIT $600 Tax rate 30 % Purchases of fixed assets $800 Depreciation expense $700 Change in working capital $50 Net income margin 10 Debt ratio 40 LOS: Discuss approaches for forecasting FCFF and FCFE. Pages 173 – 177, Spreadsheet Example In this example, we assume that sales growth continues at the same rate; the relationship between sales and EBIT margin, FCInv, and WCInv is constant; and figures are from last year’s financial statements. The solution is on the next slide.

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**Example: Forecasting FCFF & FCFE**

LOS: Discuss approaches for forecasting FCFF and FCFE. Pages 173 – 177, Spreadsheet Example We first calculate sales growth, EBIT margin, the relationship between incremental FCInv and WCInv, and sales growth.

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**Example: Forecasting FCFF**

LOS: Discuss approaches for forecasting FCFF and FCFE. Pages 173 – 177, Spreadsheet Example Next year’s sales are the previous year’s sales, $4000, plus the growth of $200 = $4200. EBIT is 15 percent of next year’s sales = $630. After-tax EBIT is $441. With sales growth of $200, incremental FC and WC is $100 and $50, respectively. Using these inputs, we arrive at FCFF = $291.

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**Example: Forecasting FCFE**

LOS: Discuss approaches for forecasting FCFF and FCFE. Pages 173 – 177, Spreadsheet Example Now we forecast FCFE. Using the given net income margin of 10 percent, we calculate next year’s net income at $420. The incremental FC and WC calculated on the previous slide are repeated here to refresh your memory. Using the given debt ratio (DR) of 40 percent, we calculate a FCFE of $330. A FCFE of $330 is equal to net income of $420 minus the incremental FCInv and WCInv financed by the 60 percent equity (1 – 0.40).

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**Issues in FCF Analysis Financial Statement Discrepancies**

Dividends vs. FCFE Effect of Shareholder Cash Flows & Leverage FCFF & FCFE vs. EBITDA & Net Income Country Adjustments Sensitivity Analysis Nonoperating Assets LOS: Contrast the ownership perspective implicit in the FCFE approach to the ownership perspective implicit in the dividend discount approach. LOS: Contrast the recognition of value in the FCFE model to the recognition of value in dividend discount models. LOS: Explain how dividends, share repurchases, share issues, and changes in leverage may affect FCFF and FCFE. LOS: Critique the use of net income and EBITDA as proxies for cash flow in valuation. LOS: Explain how sensitivity analysis can be used in FCFF and FCFE valuations. Pages 177 – 184, 194 When determining FCFF and FCFE, analysts should be aware of the following issues: Discrepancies between balance sheet items and cash flow statement items: The reasons for this are firm acquisitions/divestitures and the presence of foreign subsidiaries. The analyst should adjust cash flow projections for these contaminants. Dividends vs. FCFE: Firms with low dividends (e.g., a young start-up) usually also have low FCFE because they have large capital expenditures or are facing difficulties. However, many analysts consider FCFE more relevant than dividend discount models because 1) for firms that pay no or small dividends, future dividends are difficult to forecast; 2) for firms being valued for acquisition, the acquirer can in the future control all the firm’s cash flows (not just the dividends); and 3) FCFE is often a better indicator of future shareholder wealth because it reflects all the cash flows available to the firm, not just those paid out. Effect of dividends, repurchases, share issuances, and leverage on FCFE and FCFF: Dividends, share repurchases, share issues do not change the FCFE and FCFF because these measure the firm’s available cash flow. In other words, a stock repurchase program affects the distribution of available cash flows but not their availability. Increases in leverage (debt) do increase FCFE by the debt issue in the year issued. Future FCFE increases by the tax savings from the interest tax shield but is decreased by future interest payments to debtholders. FCFF only changes by the tax savings from the interest tax shield. FCFF and FCFE vs. EBITDA and net income: Although commonly used in valuation, EBITDA is a poor substitute for FCFF and FCFE because it does not account for depreciation, FCInv, and WCInv. Likewise, net income is a poor substitute for FCFE because it does not account for depreciation, FCInv, WCInv, and net borrowings. Country adjustments in international valuations: The analyst should adjust for differing interest rates, inflation, growth, and accounting practices. A build-up approach can be used to determine the appropriate required rate of return in a country (as discussed in Chapter 2). Real cash flows and real discount rates are frequently used instead of nominal values when inflation is high and volatile. Sensitivity analysis: Inputs such as future growth rates and the initial FCFF and FCFE can have large impacts on the calculated valuations. Therefore, the analyst should examine how valuations change with changes in each of a model’s inputs. Some variables will have a greater impact on the valuation than others. Nonoperating assets: Analysts often exclude the value of nonoperating assets such as investments in cash and marketable securities when discounting future FCFF and FCFE (which results in the value of operating assets [is there a word missing in this phrase?]). In this case, the value of cash and marketable securities should be added to the value of a firm after the present value (PV) of FCF is calculated. Value of firm = Value of nonoperating assets + Value of operating assets.

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**Simple Two-Stage FCF Models**

LOS: Discuss the single-stage (stable-growth), two-stage, and three-stage FCFF and FCFE models (including assumptions), and explain the company characteristics that would justify the use of each model. LOS: Calculate the value of a company by using the stable-growth, two-stage, and three-stage FCFF and FCFE models. LOS: Discuss approaches for calculating the terminal value in a multistage valuation model. Pages 185 – 188 As when we discounted dividends, there are two forms of FCF two-stage models. We’ll look at the first version here, referred to as the simple two-stage model. In this model, the first stage of rapid growth for n years abruptly transitions to a second stage of constant growth that exists in perpetuity. This FCF model is similar to the general two-stage dividend discount model (DDM) discussed in Chapter 3 of the text. However, the forecasts of FCF will be more complicated than forecasts of dividends because we will also need to project FCInv, WCInv, and other variables (as in the example to follow). A firm that is expected to have a high rate of growth until patents expire, for example, should be modeled by this two-stage model, with one rate of growth before the patent expires and another rate thereafter. Recall that when we are discounting FCFF, the relevant discount rate reflects all the firm’s capital, which is the WACC. When we are discounting FCFE, the relevant discount rate is the required return on equity (r). The formulas say that firm or equity value at time zero is equal to two terms: the discounted stream of FCF during the initial growth phase and the present value of the dividend stream growing in perpetuity at g (the long-term growth rate). The growth rates can be determined using FCF growth or the growth in sales or net income. If the analysts is using the latter two growth rates, they must be adjusted for changes in profit margins, operating assets, and/or financing (see the example on the slides to follow). The example on the following slides illustrate the calculation.

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**Example: Simple Two-Stage FCFE Model**

Current sales per share $10 Sales growth for first three years 20 % Sales growth for year 4 and thereafter 5 Net income margin 10 FCInv/sales growth 40 WCInv/sales growth 25 Debt financing of FCInv and WCInv growth 30 Required return on equity 12 .00% LOS: Discuss the single-stage (stable-growth), two-stage, and three-stage FCFF and FCFE models (including assumptions), and explain the company characteristics that would justify the use of each model. LOS: Calculate the value of a company by using the stable-growth, two-stage, and three-stage FCFF and FCFE models. LOS: Discuss approaches for calculating the terminal value in a multistage valuation model. LOS: Discuss approaches for forecasting FCFF and FCFE. Pages 185 – 188, Spreadsheet Example In this example, we are given the sales growth, and from that we must derive the FCFE. As an example, we’ll calculate the FCFE in year 1 on the next slide. The solution is on the next slide.

29
**Example: Simple Two-Stage FCFE Model**

LOS: Discuss the single-stage (stable-growth), two-stage, and three-stage FCFF and FCFE models (including assumptions), and explain the company characteristics that would justify the use of each model. LOS: Calculate the value of a company by using the stable-growth, two-stage, and three-stage FCFF and FCFE models. LOS: Discuss approaches for calculating the terminal value in a multistage valuation model. LOS: Discuss approaches for forecasting FCFF and FCFE. Pages 185 – 188, Spreadsheet Example For the year 1 FCFE, the FCFE is equal to the net income minus incremental FCInv and WCInv plus new debt financing. Sales in year 1 is Current sales x (1 + Sales growth rate) = $10(1.2) = $12. The change is sales is then $2. Net income is 10 percent of sales or $1.20. FCInv will increase by the sales growth times the incremental FCInv growth: $2 x 40 percent = $0.80. WCInv will increase by the sales growth times the incremental WCInv growth: $2 x 25 percent = $0.50. Of the increase in FCInv and WCInv (total 65 percent of sales growth), 30 percent will be financed by debt: $2 x 65 percent x 30 percent = $0.39. FCFE is then $1.20 – $0.80 – $ $0.39 = $0.29. The FCFE in the other years is presented on the next slide.

30
**Example: Simple Two-Stage FCFE Model**

Year 1 2 3 4 5 Sales growth in % 20% 5% Sales per share $12.000 $14.400 $17.280 $18.144 $19.051 EPS $1.200 $1.440 $1.728 $1.814 $1.905 FCInv per share $0.800 $0.960 $1.152 $0.346 $0.363 WCInv per share $0.500 $0.600 $0.720 $0.216 $0.227 Debt financing per share $0.390 $0.468 $0.562 $0.168 $0.177 FCFE per share $0.290 $0.348 $0.418 $1.421 $1.492 Growth in FCFE 20.0% 240.3% 5.0% LOS: Discuss the single-stage (stable-growth), two-stage, and three-stage FCFF and FCFE models (including assumptions), and explain the company characteristics that would justify the use of each model. LOS: Calculate the value of a company by using the stable-growth, two-stage, and three-stage FCFF and FCFE models. LOS: Discuss approaches for calculating the terminal value in a multistage valuation model. LOS: Discuss approaches for forecasting FCFF and FCFE. Pages 185 – 188, Spreadsheet Example Notice that the FCFE grows at the same rate as the sales except in year 4, when it grows at 240 percent. This is because in that year sales increase at 5 percent but incremental FCInv and WCInv decrease sharply. This is because incremental FCInv and WCInv are calculated relative to the $ growth in sales, which decreases in that year (even though absolute $ sales increases). On the next slide, we’ll discount the FCFE to obtain a stock value.

31
**Example: Simple Two-Stage FCFE Model**

LOS: Discuss the single-stage (stable-growth), two-stage, and three-stage FCFF and FCFE models (including assumptions), and explain the company characteristics that would justify the use of each model. LOS: Calculate the value of a company by using the stable-growth, two-stage, and three-stage FCFF and FCFE models. LOS: Discuss approaches for calculating the terminal value in a multistage valuation model. Pages 185 – 188, Spreadsheet Example Notice that to get the PV of the infinite stream of FCFE, we can start at the year 4 FCFE when thereafter FCFE starts to grow at the constant 5 percent rate (even though on the previous slide we forecasted FCFE out to year 5). The terminal value of $ is a large part of stock value, 94.5 percent to be exact ($ /$15.28). For this reason, an analyst may want to evaluate the terminal value using sensitivity analysis. This terminal value can also be calculated using the projected earnings and P/E ratio (as we did in Chapter 3).

32
**Declining Growth Two-Stage FCFE Model**

Initially High earnings growth Large capital expenditures Low or negative FCFE Competition Later Increases Earnings growth slows Capital expenditures decline FCFE increases LOS: Discuss the single-stage (stable-growth), two-stage, and three-stage FCFF and FCFE models (including assumptions), and explain the company characteristics that would justify the use of each model. LOS: Calculate the value of a company by using the stable-growth, two-stage, and three-stage FCFF and FCFE models. LOS: Discuss approaches for calculating the terminal value in a multistage valuation model. LOS: Discuss approaches for forecasting FCFF and FCFE. Pages 188 – 192 Instead of assuming that growth drops sharply from the first to second stage, we could also assume that growth gradually declines. This is the second form of the two-stage FCF model we examine. It is sometimes the case that a small firm has rapidly increasing earnings but low or negative FCFE due to high capital expenditures. Eventually competition slows the firm’s earnings growth, but FCFE increases because the firm can reduce capital spending as it matures. Equity valuation is then largely dependent on these later FCFs. That is the assumption in the example to follow. In the real world, analysts may want to evaluate the FCFs of firm subsidiaries, and then aggregate the FCFs to arrive at total firm or equity value.

33
**Example: Declining Growth Two-Stage FCFE Model**

Current EPS $1 .00 WCInv/FCInv 40 % Debt financing of FCInv and WCInv growth 30 Required return on equity 12 EPS and FCInv growth for year 5 and thereafter 5 LOS: Discuss the single-stage (stable-growth), two-stage, and three-stage FCFF and FCFE models (including assumptions), and explain the company characteristics that would justify the use of each model. LOS: Calculate the value of a company by using the stable-growth, two-stage, and three-stage FCFF and FCFE models. LOS: Discuss approaches for calculating the terminal value in a multistage valuation model. LOS: Discuss approaches for forecasting FCFF and FCFE. Pages 188 – 192, Spreadsheet Example In this example, we are given the EPS, and from that we must derive the FCFE. Additional assumptions are provided on the next slide.

34
**Example: Declining Growth Two-Stage FCFE Model**

Year 1 2 3 4 5 EPS growth 30% 21% 13% 8% 5% FCInv per share $1.50 $1.25 $1.00 $0.75 $0.50 LOS: Discuss the single-stage (stable-growth), two-stage, and three-stage FCFF and FCFE models (including assumptions), and explain the company characteristics that would justify the use of each model. LOS: Calculate the value of a company by using the stable-growth, two-stage, and three-stage FCFF and FCFE models. LOS: Discuss approaches for calculating the terminal value in a multistage valuation model. LOS: Discuss approaches for forecasting FCFF and FCFE. Pages 188 – 192, Spreadsheet Example Notice that EPS and FCInv are gradually slowing. We’ll calculate the FCFE in year 1 on the next slide.

35
**Example: Declining Growth Two-Stage FCFE Model**

LOS: Discuss the single-stage (stable-growth), two-stage, and three-stage FCFF and FCFE models (including assumptions), and explain the company characteristics that would justify the use of each model. LOS: Calculate the value of a company by using the stable-growth, two-stage, and three-stage FCFF and FCFE models. LOS: Discuss approaches for calculating the terminal value in a multistage valuation model. LOS: Discuss approaches for forecasting FCFF and FCFE. Pages 188 – 192, Spreadsheet Example For the year 1 FCFE, the FCFE is equal to the EPS minus incremental FCInv and WCInv plus new debt financing. EPS in year 1: Current EPS x (1 + Sales growth rate) = $1.00(1.3) = $1.30. The FCInv is given at $1.50. WCInv will increase by 40 percent times the incremental FCInv growth: $1.50 x 40 percent = $0.60. Of the increase in FCInv and WCInv, 30 percent will be financed by debt: ($ $0.60) x 30 percent. FCFE is then $1.30 – $1.50 – $ ($ $0.60) x 30 percent = –$0.17. The FCFE in the other years is presented on the next slide.

36
**Example: Declining Growth Two-Stage FCFE Model**

Year 1 2 3 4 5 EPS $1.300 $1.573 $1.777 $1.920 $2.016 FCInv per share $1.500 $1.250 $1.000 $0.750 $0.500 WCInv per share $0.600 $0.400 $0.300 $0.200 Debt financing per share $0.630 $0.525 $0.420 $0.315 $0.210 FCFE per share –$0.170 $0.348 $0.797 $1.185 $1.526 LOS: Discuss the single-stage (stable-growth), two-stage, and three-stage FCFF and FCFE models (including assumptions), and explain the company characteristics that would justify the use of each model. LOS: Calculate the value of a company by using the stable-growth, two-stage, and three-stage FCFF and FCFE models. LOS: Discuss approaches for calculating the terminal value in a multistage valuation model. LOS: Discuss approaches for forecasting FCFF and FCFE. Pages 188 – 192, Spreadsheet Example Notice that the FCFE starts out negative but then gradually increases because FCInv and WCInv are slowing and EPS is still growing (albeit at a slower rate). On the next slide, we’ll discount the FCFE to obtain a stock value.

37
**Example: Declining Growth Two-Stage FCFE Model**

LOS: Discuss the single-stage (stable-growth), two-stage, and three-stage FCFF and FCFE models (including assumptions), and explain the company characteristics that would justify the use of each model. LOS: Calculate the value of a company by using the stable-growth, two-stage, and three-stage FCFF and FCFE models. LOS: Discuss approaches for calculating the terminal value in a multistage valuation model. LOS: Discuss approaches for forecasting FCFF and FCFE. Pages 188 – 192, Spreadsheet Example Notice that the terminal value is estimated at $21.80, which is the PV at year 4 of the FCFE that grows at a constant 5 percent rate forever. When we discount this back to year 0, we obtain a $ PV for the perpetual stream. We determine the total value of the stock to be $ On the next slide, we’ll calculate a P/E for years 0 and 4, assuming that the present value we calculated will equal the stock price.

38
**Example: Declining Growth Two-Stage FCFE Model**

LOS: Discuss the single-stage (stable-growth), two-stage, and three-stage FCFF and FCFE models (including assumptions), and explain the company characteristics that would justify the use of each model. LOS: Calculate the value of a company by using the stable-growth, two-stage, and three-stage FCFF and FCFE models. LOS: Discuss approaches for calculating the terminal value in a multistage valuation model. LOS: Discuss approaches for forecasting FCFF and FCFE. Pages 188 – 192, Spreadsheet Example Note that the P/E is greater at year 0 than at year 4 because the EPS growth rate has gradually declined through time.

39
**Example: Three-Stage FCF Models**

Current FCFF in millions $100 .00 Shares outstanding in millions 300 Long-term debt value in millions $400 FCFF growth for years 1 to 3 30 % FCFF growth for year 4 24 FCFF growth for year 5 12 FCFF growth for year 6 and thereafter 5 WACC 10 LOS: Discuss the single-stage (stable-growth), two-stage, and three-stage FCFF and FCFE models (including assumptions), and explain the company characteristics that would justify the use of each model. LOS: Calculate the value of a company by using the stable-growth, two-stage, and three-stage FCFF and FCFE models. LOS: Discuss approaches for calculating the terminal value in a multistage valuation model. Pages 192 – 194, Spreadsheet Example There are two approaches we could use when working with the three stages of FCF growth. One approach is to assume that growth is constant in each of the three stages. Another approach would be to assume that growth is constant in stages 1 and 3 but gradually declines in stage 2. We make the latter assumption in this example where we discount FCFF using the WACC. We will work with a direct forecast of FCFF, instead of forecasting it from inputs of income, capital expenditures, and debt financing (as we did for the two-stage model examples). The solution is on the next slide.

40
**Example: Three-Stage FCF Models**

Year 1 2 3 4 5 6 FCFF growth rate 30% 24% 12% 5% FCFF $130.0 $169.0 $219.7 $272.4 $305.1 $320.4 PV of FCFF $118.2 $139.7 $165.1 $186.1 $189.5 LOS: Discuss the single-stage (stable-growth), two-stage, and three-stage FCFF and FCFE models (including assumptions), and explain the company characteristics that would justify the use of each model. LOS: Calculate the value of a company by using the stable-growth, two-stage, and three-stage FCFF and FCFE models. LOS: Discuss approaches for calculating the terminal value in a multistage valuation model. Pages 192 – 194, Spreadsheet Example The FCFF are projected here by growing FCFF at the respective growth rates. They are then discounted at the WACC of 10 percent to determine their PV. The terminal value calculation is on the next slide.

41
**Example: Three-Stage FCF Models**

LOS: Discuss the single-stage (stable-growth), two-stage, and three-stage FCFF and FCFE models (including assumptions), and explain the company characteristics that would justify the use of each model. LOS: Calculate the value of a company by using the stable-growth, two-stage, and three-stage FCFF and FCFE models. LOS: Discuss approaches for calculating the terminal value in a multistage valuation model. Pages 192 – 194, Spreadsheet Example To calculate the PV of the terminal value at time zero, we discount the year 6 FCFF of $320.4 using the constant-growth formula. We then discount this amount back five periods using the WACC of 10 percent to obtain $3979.

42
**Example: Three-Stage FCF Models**

LOS: Discuss the single-stage (stable-growth), two-stage, and three-stage FCFF and FCFE models (including assumptions), and explain the company characteristics that would justify the use of each model. LOS: Calculate the value of a company by using the stable-growth, two-stage, and three-stage FCFF and FCFE models. LOS: Discuss approaches for calculating the terminal value in a multistage valuation model. Pages 192 – 194, Spreadsheet Example The total firm value is the PV of future FCFF discounted at the WACC. Using the inputs from the previous slides, we have $4,777. To obtain the equity value of $4,377, we subtract the market value of debt from the firm value. Dividing by the number of shares (300), we obtain a per share value of $14.59.

43
**Summary FCFF = Cash flow available to all firm capital providers**

FCFE = Cash flow available to common equityholders FCFF is preferred when FCFE is negative or when capital structure is unstable FCFF vs. FCFE Discount FCFF with WACC Discount FCFE with required return on equity Equity value = PV(FCFF) – Debt value or PV(FCFE) Equity Valuation with FCFF & FCFE Pages

44
Summary Depreciation, amortization, restructuring charges, capital gains/losses, employee stock options, deferred taxes/tax assets Adjustments for Calculating Free Cash Flows Sources – adjust for noncash events and work from … Net income EBIT EBITDA CFO Uses Δ in Cash balances and net payments to debtholders and stockholders Approaches for Calculating FCFF & FCFE Pages 194 – 196

45
**Financial statement discrepancies Dividends vs. free cash flows **

Summary Financial statement discrepancies Dividends vs. free cash flows Shareholder cash flows and leverage FCFF & FCFE vs. EBITDA & Net income Country adjustments Sensitivity analysis Nonoperating assets Issues in FCF Analysis Pages 194 –196

46
**Forecasting FCFF & FCFE**

Summary Forecast sales growth Assume EBIT margin, FCInv, and WCInv are proportional to sales For FCFE, assume debt ratio is constant Forecasting FCFF & FCFE Two-stage with distinct growth in each stage Two-stage with declining growth from stage 1 to 2 Three-stage model FCF Valuation Models Pages 194 – 196

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FI3300 Corporate Finance Spring Semester 2010 Dr. Isabel Tkatch Assistant Professor of Finance 1.

FI3300 Corporate Finance Spring Semester 2010 Dr. Isabel Tkatch Assistant Professor of Finance 1.

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